All change for construction contract arrangements?
April 2022 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2022 Issue
There have been significant recent shifts in the construction industry, including significant price inflation. In parallel, across the public and private projects space, debates continue to rage as to the right way in which pricing mechanisms should allocate risk in order to attract value financing.
Furthermore, some models of private financing perceive themselves to be dependent on forms of construction contract pricing mechanisms which are somewhat out of fashion (i.e., project financing has traditionally been seen as dependent on the implementation of fixed price engineering, procurement and construction (EPC) turnkey type construction arrangements).
In this article, we assert that while the pricing mechanic is important – it is not now, nor has it ever been, the primary driver of the value and financeability of a project. Issues facing the construction market at present are complex and, much more than any simple one size fits all pricing panacea, what is needed is an intelligent, detailed consideration of risk allocation. It is our assertion that this has always been the case.
Background
There is a conventional view that most historic project finance transactions have been built on the back of fixed price, lump sum construction arrangements. Under this arrangement, the contractor takes the lion’s share of construction risk. This leaves limited risk in the financed project vehicle (i.e., the employer under the construction contract), thus enabling limited recourse financing at a reasonable cost.
Even in non-project financed deals, namely those corporately financed construction projects, in the regulated sectors or government funded construction arrangements, there has been an historic desire for cost certainty and fixed price, lump sum arrangements.
However, over the past decade and certainly since the UK’s abolition of Private Finance 2 (PF2) in 2018, there has been a widespread shift in the construction market, with contractors becoming less and less willing to bear the risk of fixed price, lump sum arrangements. Instead, target cost arrangements – particularly the new engineering contract (NEC) Option C form, whereby risks of a cost overrun are shared with the employer – have become widespread in UK civil infrastructure in the public and regulated sectors (Thames Tideway Tunnel and HS2 are major examples in both the private and publicly financed sectors respectively).
More recently still, there have been more pervasive shifts in the construction market. These have been triggered by widespread cost inflation of raw materials caused by Brexit and the pandemic and, more specifically, by: (i) international shipping delays and shortage of haulage drivers; (ii) rising importing costs of key technology and materials; (iii) insufficient supply of workforce (e.g., bricklayers, carpenters, plasterers, electricians and plumbers); and (iv) escalating gas prices.
These issues have led to contractors expressing concern about the target cost form of agreement. For, in a world where a contractor’s day one target cost forecast can double, generalised cost risk sharing is not a viable solution. This has led to calls for use of cost reimbursable or alliance type arrangements where the employer takes a much larger share of construction cost outturn risk. While the call for these arrangements makes sense for the contractor market, there is a legitimate question about how viable this approach is for public, private and project financed solutions.
The basics
Broadly, there are three forms of construction contract price arrangement, as outlined below.
Fixed price, lump sum. This arrangement is where the contractor agrees to deliver the works for a fixed price subject to certain agreed reopeners. A fixed price contract is perceived to be appropriate where the work is well defined and it is unlikely that there will be any significant changes to the requirements, as this allows the contractor to accurately price the work. Outside of relevant reopeners, the contractor carries the cost risk. If the cost of the work exceeds the agreed price, the contractor will earn a smaller profit or even make a loss. This model is perceived to provide enhanced cost certainty for employers.
Target price. Under a target price contract, the parties agree a target price for the work and the agreed formula for sharing any cost savings or overruns. Target costs might be set for the overall project, or for specific elements of the work. A target price contract is appropriate where the parties have sufficient knowledge and experience to accurately estimate the likely cost of the work and to negotiate and agree the formula for ‘pain/gain’ share. Under a target price contract, the contractor is then paid during the works for its actual costs on a reimbursable basis plus fee. Once the works are complete, the total cost paid to the contractor is compared against the target with any underspend or overspend being shared between the parties in accordance with the pre-agreed ‘pain/gain’ formula.
Cost reimbursable. Under a cost reimbursable contract, the contractor is entitled to be reimbursed for the actual costs it incurs in carrying out the work plus a pre-agreed lump sum or percentage fee to cover its overheads and profit. A cost reimbursable contract is perceived to be appropriate where the nature or scope of the work cannot be precisely defined at the outset and the risks associated with the works are high, for example with urgent alteration or repair work.
Perception issues
Historically, fixed price, lump sum arrangements were sought to provide cost certainty. This was particularly true in public-private partnership (PPP) type project financings, where limited recourse debt was provided, and certainty of project costs was a primary objective.
However, with the collapse of Carillion, there has been a general trend away from seeking to pass most or all cost risk onto contractors. Instead, many employers are now taking a more equitable view with risk being retained by the party best able to effectively manage it (this is the key message regarding risk allocation in the UK government’s ‘Sourcing Playbook’).
Major UK civil projects have favoured what is seen as a more collaborative form of contracting – namely the target cost form of contract – where cost overrun risk is shared. There has also been a growing trend for the use of cost reimbursable type arrangements in the shorter term. This is not surprising when inflation is rising in core components that form the basis of construction cost estimates. There have been some examples where day one forecast costs have been exceeded by over 100 percent and this has led to a reticence among contractors to take even partial cost risk without expansive reopeners. Rather, there has been a call for cost reimbursable models where cost risk has been constrained to fee as opposed to actual costs.
The challenge has come from employers and those operating in the infrastructure finance space, as to how projects can operate (and attract finance at value) with such lingering cost uncertainty and such shifts in the construction market.
The wrong debate
There have undoubtedly been market shifts, but the question is not solely which pricing model to use. Debates as to which of the above forms of pricing model are appropriate or ‘solve’ the problem are far too simplistic. All too often, generalisations are put forward as to why one pricing model is superior to another – these assertions are nearly always wrong.
As such, it is not the case that without fixed price, lump sum arrangements finance cannot be attracted at value. Nor is it the case that target cost contracting creates a collaborative counter claims culture, or that cost reimbursable models cannot be developed with a level of cost control.
Back in the days of complex private finance initiatives (PFIs), the fixed price construction contract was never truly that. While the price for the works was fixed to some degree, there were often a number of price reopeners. While some price reopeners were standard (e.g., variations to the scope made by an employer), others were project specific, including unforeseen ground conditions. Further, contractor’s prices may have included provisional sums for certain aspects of work they could not price at the outset. All this is to say that there never was such a thing as a truly fixed price construction arrangement in UK infrastructure.
Similarly, the target price contract does not create the panacea of collaboration that its most ardent promoters promise. We have seen a number of major projects inundated by claims for compensation events to inflate the target price. There is no rational reason to consider that just because a contractor is exposed to a proportion rather than 100 percent of a cost overrun, it will somehow be more indifferent as to the cost outcome or the cost risk that it bears. As such, use of a target price arrangement does not of itself prevent a claims culture. Further, target price contracting has often, mistakenly, led to fee escalation with fees being expressed as a function of expenditure and not performance.
Market shifts
The construction market is challenging at present. Margins for contractors are low, meaning contractors can legitimately only bear so much risk. Plainly, this is a problem for employers too as (absent security) every risk is an employer’s risk once your chosen contractor has become insolvent.
Contrary to popular opinion, none of this can be solved by just adopting one form of pricing model over another. In reality, distinctions between pricing models are not as stark as their names suggest. For instance, a fixed price contract with a large number of relevant reopeners is not all too dissimilar from a cost reimbursable contract with performance and cost incentives.
The perennial challenge for employers therefore remains fully understanding construction risks inherent in the project and allocating them appropriately with best value in mind. While the nature of the risks has shifted over time, this issue itself has always been the challenge for employers (including those employers trying to attract private finance).
There is no single pricing model which delivers the solution. Instead, a tailored solution considering issues such as fee, resilience, incentives and pass-through risks, including inflation and change in law, in the context of the specific project is what is required. Notwithstanding that the market is volatile at present, this is as true now as it ever was.
Steve Gummer is a partner and Allan Owen is an associate at Sharpe Pritchard Solicitors. Mr Gummer can be contacted on +44 (0)20 7405 4600 or by email: sgummer@sharpepritchard.co.uk. Mr Owen can be contacted on +44 (0)20 7405 4600 or by email: aowen@sharpepritchard.co.uk.
© Financier Worldwide
BY
Steve Gummer and Allan Owen
Sharpe Pritchard Solicitors
Infrastructure & project finance
An uneven recovery ahead for airports
Waste to energy – too much risk for too little reward?
All change for construction contract arrangements?
A comparative view on the approach to ESG in PPP financing for roads in Latin America
Local authority commercialisation through innovative funding solutions